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1 ARE YOU TAKING THE WRONG FX RISK? Focusing on transaction risks may be a mistake Structural and portfolio risks require more than hedging Companies need to understand not just correlate the relationship between foreign exchange movements and cashflows Bruno Coppé Michael Graham Timothy M. Koller IN THE COMPANION article, Why derivatives don t reduce FX risk, Tom Copeland and Yash Joshi argue from a macro perspective that FX risks are oƒten swamped by other risks and that therefore using FX derivatives is not likely to substantially reduce a company s cash flow volatility. This article explores the topic from another angle. First, how should an individual company identify and measure its foreign exchange risk? Second, what can it do about it? Identifying and measuring FX risk is far from easy. Few CFOs, even among the best, measure more than a small portion of their overall risk. Many companies manage only visible and easily Bruno Coppé is a consultant and Michael Graham is a principal in McKinsey s Brussels oƒfice. Tim Koller is a partner in the Amsterdam oƒfice. Copyright 1996 McKinsey & Company. All rights reserved. THE McKINSEY QUARTERLY 1996 NUMBER 1 81

2 quantifiable risks, such as exposure to foreign currency liabilities. And CFOs seldom comprehend all the risks in their business. They may not understand, say, the relationship between exchange rates and the local prices in the markets where they sell their products. Nor do many CFOs appreciate all the limitations of the tools they use to manage their risks. Swaps, for instance, require margin accounts to protect the counterparty from credit risk. These margin accounts may distort the cashflows derived from the instrument. These gaps in understanding suggest there is a need for a systematic process for thinking about and examining risk. However well informed, intuition about where risks lurk can lead people badly astray. Indeed, close analysis reveals that even the most astute CFO or treasurer may find their company s risk exposure is the opposite of what they suspected. Three types of FX risk Foreign exchange risk the impact of FX rate changes on the value of a company and/or on the volatility of its cashflows is not really one thing, but three: structural risk, transaction risk, and portfolio risk. Breaking risk down in this way helps companies improve their understanding of the economics that drive FX exposure. This is particularly important for large multinationals with complex operations. Few CFOs, even among the best, measure more than a small portion of their overall risk Structural risk occurs when there is a mismatch between cash inflows and outflows, due either to diƒferences in the currencies in which those cashflows are denominated or to the influence of exchange rate fluctuations. Take, in the first instance, the classic example of an exporter that produces goods in country A and sells them in country B at a price in B s currency. This exporter is competing for customers with producers that manufacture in country B and have costs in B s currency. Or consider, in the second instance, the less obvious example of a paper company that is entirely domestic in its operations. Although it produces and sells its paper exclusively at home, its competitors may be importing from other countries and thus benefiting from advantageous foreign exchange rates. Transaction risk derives from time lags. Suppose a company makes a purchase in a currency other than its normal operating currency and agrees to pay for the goods 1 days later. It has a transaction exposure because of the time lag between when it commits to pay in the foreign currency and when it actually makes the payment. 82 THE McKINSEY QUARTERLY 1996 NUMBER 1

3 Portfolio risk arises when businesses operate in several diƒferent currencies. Take McDonald s, which owns and operates restaurants around the world. Each restaurant tends to have as its natural currency the local currency in which it operates. Its revenues are denominated in the local currency, its purchases are mostly made in the local currency, and its competitors are mainly local competitors. In local currency terms, it has no foreign exchange risk. But to the extent that McDonald s shareholders are interested in, say, US dollars, they will be subject to foreign exchange risk when the company s profits and Once a company has identified and measured its FX risk, it can turn to developing risk management strategies cashflows from foreign operations are translated back into US dollars. One way to think about the diƒference between structural and portfolio risk is that structural risk is about the risks within the income statement that arise out of mismatches between revenues and costs, while portfolio risk has to do with the translation of a company s profit and loss back into its home currency. Portfolio risk tends not to be related to a company s competitive position; structural risk is all about competitive position. These three diƒferent risks are also accounted for diƒferently. (This is important, since managers, rightly or wrongly, are oƒten influenced by the accounting impact of their decisions.) Transaction risk shows up in a company s income statement as a line called foreign exchange gains or losses (which is oƒten the responsibility of the Treasury department). Structural risk shows up as higher or lower operating profits and margins and is not generally easy to trace. Portfolio risk, like structural risk, shows up as higher or lower operating profits once translated into the parent currency, though local-currency operating profits are not aƒfected. In addition, some of the future impact of portfolio risk shows up in the cumulative translation adjustment in a company s equity accounts based on the exchange rate impact on assets and liabilities. operations Shareholders (Germany) Exhibit 1 Disaggregating the risks Let s explore risk disaggregation by means of a simplified, disguised example. Euro- Industries is a German company that processes and sells commodity chemicals at home and in the United States (Exhibit 1). Both the products it sells and its primary raw materials are priced in US dollars, since (Germany) HQ (Germany) Revenues Raw materials Production costs Capital expenditures (United States) THE McKINSEY QUARTERLY 1996 NUMBER 1 83

4 they are perceived as world commodities. The German and US sides of the business are equal in size and profitability. US operations have no structural risk; in other words, there is no mismatch between revenues and costs. Both are in US dollars, the natural currency for the US business. structural risk Exchange rate Index: 199 = Exhibit 2 Gross margin 6 4 At first glance, German operations appear to have substantial structural risks. Euro- Industries Germany pays dollars for its raw materials, spends Deutschemarks on processing the chemicals in a factory in Germany that was purchased with Deutschemarks, and then sells the finished products for US dollars Closer examination, however, produces some surprising insights. Although Germany s revenues and a major portion of its costs are in US dollars, it faces virtually no US dollar risk. This is because the spread between its finished product prices and its raw materials costs is not correlated with the level of, or changes in, the dollar/deutschemark exchange rate (Exhibit 2). How can this be? First, the market for the raw materials that purchases is truly international. Prices are the same worldwide. Second, the market for the finished products that Germany sells in Europe is a European market, despite the fact that prices are quoted in US dollars. All Germany s competitors are European companies with plants in Europe and costs in European currencies (except for raw materials costs). In fact, thanks to relatively high transportation costs, almost no finished product crosses the ocean between Europe and the United States. As a result, prices are not linked across the Atlantic. transaction risk (1) Cash cycle Day Commit to purchase raw materials Receive raw materials, book purchase Pay for raw materials Exhibit 3 Sell finished product and receive cash does, however, face a short-term transaction risk owing to mismatches in the timing of its German operations cashflows. Euro- Industries Germany buys raw materials in US dollars about 21 days before it pays for them (Exhibit 3). It 84 THE McKINSEY QUARTERLY 1996 NUMBER 1

5 will thus experience an exchange gain or loss if the FX rate changes during this 21-day period. This gain or loss is both an accounting gain or loss and an economic gain or loss. Oƒfsetting this gain or loss is an inventory gain or loss. takes about 28 days to process raw materials into finished goods and deliver them to customers. It sells these finished products at prices that reflect the spot commodity price and spot exchange rate on the day of the sale. has found that finished goods spot prices change almost immediately in response to fluctuations in raw materials prices and exchange rates. Accordingly, it will experience an exchange gain or loss on its inventory. This gain or loss is a real economic gain or loss, but shows up in accounting statements in the form of higher or lower operating margins. For simplicity, we will assume that, like everyone else, prices its products in line with US dollar prices, but that it accepts payment in Deutschemarks at the spot rate at the time of sale. Hence the company experiences no FX gains or losses on its receivables. Overall, transaction risk equals the net of its inventory less its dollar payables. Unfortunately, however, the accounting eƒfects of oƒfsetting exposures are recorded diƒferently. Inventory gains and losses are reflected in operating profits, while gains and losses on payables show up as exchange gains and losses (Exhibit 4). Since originally defined its risk as the accounting gains and losses it incurred, it considered itself to be short in dollars (because of its US payables), when in fact it was long in dollars (because its inventories exceeded its payables). Its accounting gains and losses do not correspond to its economic exposure (Exhibit 5). is owned mainly by German shareholders who are ultimately interested in consuming in transaction risk (2) Typical transaction Revenues Raw materials Gross profit FX gain Adjusted gross profit Base case falls 1% before booking No need to hedge transaction risk (3) before raw material payment No need to hedge Accounting gains/losses are not the same as economic exposure Hedge policy Minimize reported FX gains and losses Minimize economic gain or loss Action Exhibit 4 after raw material payment Hedge inventory after payment Exhibit 5 Hedge payable by buying from day 9 to day 21 Hedge inventory by selling from day 21 to day 28 THE McKINSEY QUARTERLY 1996 NUMBER 1 85

6 portfolio risk Base value of after 5% decline in (Germany) 5 5 (United States) , % Exhibit 6 Deutschemarks. From their perspective, the company faces portfolio risk because the cashflows from its US operations will vary with changes in the dollar/deutschemark exchange rate (Exhibit 6). About half of Euro- Industries value is exposed to such changes. A 5 percent decline in the dollar would therefore produce a 2.5 percent decline in the company s present value expressed in Deutschemarks. (Whether or not shareholders or managers should be concerned about this risk is not addressed here.) What to do Once a company has identified and measured its foreign exchange risk, it can turn to developing risk management strategies. The bad news is that derivatives alone (despite the publicity) cannot meet all the risk management demands of a large multinational corporation. Transaction risk is easy to manage, but tends to be relatively small in scale. Structural and portfolio risk, however, can seldom be fully managed at a reasonable cost with the financial products currently available. A company can therefore either accept these risks, which may make sense if they pose no threat to its financial health, or employ operating strategies to reduce them. If neither option appeals, it will have to search for other solutions. As we discuss possible ways to manage FX risk, keep in mind that the objectives of risk management are not universally agreed upon. At one extreme, few would argue that managers should not try to reduce the risk of financial distress caused by FX fluctuations. On the other hand, it is not clear whether or not there are benefits from reducing small fluctuations in cashflow volatility or from attempting to hedge the net present value of a business. Structural risk The bad news is that derivatives alone cannot meet all the risk management demands of a large multinational corporation In many ways, structural risk is the most important FX risk because a mismatch between cash inflows and outflows can cause financial distress. But using financial instruments to reduce structural risk may be ineƒfective, particularly if a company s investment cycle in other words, the time it takes to increase or decrease capacity is long. Indeed, the length of its investment cycle may determine a company s ability to reduce structural risk. 86 THE McKINSEY QUARTERLY 1996 NUMBER 1

7 Since has no structural risk, let s consider another company, Machine Co. It manufactures machine tools in Germany and sells them at home and in the United States. In the latter, it competes only against USbased manufacturers. All its costs are in Deutschemarks. As a result, Machine Co. faces significant structural risk. A long-term decline in the dollar (relative to purchasing power parity) could transform its profits into losses. How can a company begin to manage such risks? To a limited extent, borrowing in the currency in which you are long can reduce your structural risk. Although it is a German company, Machine Co. should borrow in US dollars. Derivatives will do little to help companies with long investment cycles manage structural risk, for two reasons. First, the market for long-term derivatives is very illiquid and therefore expensive. Second, if a company were to purchase a large quantity of derivatives relative to its total value, these derivatives become a large portion of the company s total value and therefore represent a large credit risk to its counterparties. These counterparties, in turn, will expect to be compensated for this credit risk if they are willing to undertake it at all. Indeed, derivatives may not even substantially reduce the risk of financial distress. In businesses with short investment cycles, however, they can be used to minimize short-term risks. Over the longer term, such companies do not face a high probability of financial distress because they can reduce capacity quickly. All the same, they would probably not find it economic to use derivatives to hedge the present value of their business. Operating strategies such as shiƒting production facilities to tie in with customer markets may be needed in order to reduce the risk of financial distress substantially. Such strategies are not, of course, always possible or competitively desirable. Transaction risk Derivatives will do little to help companies with long investment cycles manage structural risk This is the risk that many companies have in mind when they refer to FX risk management. But transaction risk is oƒten small. In case, its transaction risk is only about a tenth the size of its portfolio risk. A 1 percent decline in the dollar would reduce the company s value by 2.5 percent through portfolio risk, but only.3 percent through transaction risk. THE McKINSEY QUARTERLY 1996 NUMBER 1 87

8 Managing transaction risk is relatively straightforward because each transaction is identifiable and generally short term. The easiest approach is to use derivatives to hedge each individual transaction. If a company has many FX transactions, however, this can lead to high personnel and systems costs, as well as substantial expenses in the form of spreads or commissions to financial institutions. In many cases, a company can reduce these costs by hedging its net position rather than each individual transaction, in much the same way as financial institutions manage their own positions. The problem with using derivatives to hedge transaction risk is that the correct hedges may be inconsistent with the company s structural risk. Though fairly simple in itself, transaction hedging can be eƒfective only if it is informed by a comprehensive understanding of structural risks. Portfolio risk By itself, portfolio risk is unlikely to cause financial distress or bankruptcy as long as a company s capital structure is aligned with its business portfolio. Consider. If the dollar falls against the Deutschemark, its dollar cashflows will be worth fewer Deutschemarks, but they will not turn negative. The decline in the Deutschemark value of each year s cashflow will be broadly proportionate to the decline in the dollar. As long as borrowings are roughly in line with the currencies in which it generates cashflow, its risk of financial distress from exchange rate changes will be minimal. Borrowing in the currency of foreign cashflows is an eƒfective and inexpensive way to partly hedge the present value of foreign operations. This value will change roughly in proportion to the change in the value of the debt. Provided it is structured properly, Correctly using derivatives to hedge transaction risk may be inconsistent with the company s structural risk borrowing in the currency of foreign operations can also reduce cashflow volatility. Using derivatives to manage portfolio risk may be very diƒficult. For a start, long-term financial instruments are expensive. Euro- Industries US dollar cashflows over the next five years represent only about 2 percent of the present value of its US operations, and just 1 percent of total company value. For hedging its value to have a significant impact, would need to purchase instruments such as swaps or forwards with lives longer than five years. These would probably be costly, for the reasons described in the discussion of structural risk. Moreover, projecting the value of cashflows generated by a company like is highly uncertain, making it diƒficult to determine how much to hedge. might well find, too, that other risk factors 88 THE McKINSEY QUARTERLY 1996 NUMBER 1

9 such as commodity prices have a much greater impact on its value than do FX rates, further complicating the question of how many hedges to buy. Finally, hedging portfolio risk with financial instruments is likely to have adverse accounting eƒfects. Any long-term hedges will probably have to be marked to market every year because the cashflows being hedged are uncertain. As a result, could experience big swings in reported accounting exchange gains or losses from its hedges in the near term, even though these gains or losses will be oƒfset by operating gains or losses over the longer term. Questions remain Breaking risk down into these three categories and working systematically through each will clarify the risks that a company faces and suggest actions to reduce or moderate them. Such a strategy is certainly superior to current derivatives-focused approaches, but it is far from being the last word on the topic. Risk management is a highly complex field, and there are still a number of fundamental questions that must be answered if it is to continue to evolve: 1. How should we quantify each type of risk? Should we use a value-at-risk concept, or a percent impact on value or cashflows, or some combination of these? 2. Can we improve our understanding of FX rate behavior to the point where we know when we do not need to manage FX risk? If FX rates always moved to equilibrium levels (based on purchasing power parity) within five years and we could predict these levels, for example, longer-term risk might not be that critical. 3. What should our risk management objectives be? Minimizing financial distress as an objective is hard to dispute, but stabilizing the net present value of cashflows might not benefit shareholders if its cost is too high. 4. What are the true costs of hedging instruments? How can we understand them and relate them to the benefits? 5. Finally, how can we fill in the gaps in our risk management strategies? Can we find new financial instruments to do the job? THE McKINSEY QUARTERLY 1996 NUMBER 1 89

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